Paul Hiebert Marrying the cyclical and structural dimensions of ... · Pre-crisis toolkit lacked instruments to tackle the financial cycle • Buildup of country vulnerabilities •

Marrying the cyclical and structural dimensions of systemic risk The views expressed are those of the presenter

and not necessarily those of the ECB.

Paul Hiebert Head of Systemic Risk and Financial Institutions Division

Macroprudential policy conference – while the sun is shining, prepare for a rainy day

Copenhagen, 19 November 2018

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Background: Compartmentalised concepts of systemic risk

Measurement: Compartmentalised èmpirics of systemic risk: • Cyclical dimension: The financial cycle • Structural dimension: Conditional distress in banks

An approach to tackle the endogeneity of systemic risk 3

Policy considerations 4

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Compartmentalised…

Macroprudential policies (system vs institution level)

Empirical approaches (cyclical vs structural)

Academic literature (risk buildup vs amplification/contagion)

Background

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Pre-crisis toolkit lacked instruments to tackle the financial cycle

• Buildup of country vulnerabilities

• Country spillovers and contagion

Financial system dimension

Policy domain Objective

Systemic risk

treated as

Micro-prudential supervision and

regulation

Ensure soundness of individual financial

institutions

exogenous

Macro-prudential oversight Limit systemic

risk

Increase resilience endogenous

Lean against the financial

cycle

endogenous

4

Background

Policies to tackle systemic risk in banks and financial systems

Financial institutions dimension

(Micro-)prudential regulation underestimated amplification and contagion

• Feedbacks system and bank

• Contagion across institutions

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Risk Build-up

Amplification of Shocks

Phase

Source: ECB Financial Stability Review (2018), May

Cyclical and structural dimensions of systemic risk

Background

Risk materialisation

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Source: Benoit et al (2017), “Where the Risks Lie: A Survey on Systemic Risk”, Review of Finance, 21 (1), March.

4/ ”Global measures”

3/ Interconnectedness- contagion

1/ Systemic risk indicators

2/ Amplification

Mapping the academic literature

Background

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Measurement: Compartmentalised empirics of systemic risk: • Cyclical dimension: The financial cycle • Structural dimension: Conditional distress in banks



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Leverage (credit and asset prices) and the build-up of system imbalances

• Leveraged bubbles (Fisher 1933; Jordà et al. 2015)

• Credit market frictions imply state of balance sheet matters for borrowing

• Leverage cycles (Geanakopolos 2010) • Real estate as collateral constraint (Iacoviello 2005) • Equity and corporate bond valuations (Gilchrist et al. 2009 and 2012)

A spectral method capturing comovement of credit and asset prices

• Narrow (credit, real estate) vs broad (credit, prices across all asset markets – i.e. real estate, equity, bond)

• Method exploiting coherence (across frequencies) and comovement (across time)

The financial cycle

“The following definition seems to capture what experts refer to as the business cycle:

The business cycle is the phenomenon of a number of important economic aggregates … being characterized by high pairwise coherences … This definition captures the notion of the business cycle as being a condition symptomizing the common movements of a set of aggregates.”

- T. Sargent (1987), Macroeconomic Theory, p. 282 [emphasis added]

Source: Schüler, Hiebert, Peltonen (2017), “Coherent financial cycles for G-7 countries: Why extending credit can be an asset” ESRB working paper No. 43.

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An estimated financial cycle for the euro area

The financial cycle

Source: Schüler, Hiebert, Peltonen (2015), “Characterising the financial cycle: a multivariate and time-varying approach” ECB Working paper 1846 Note: EA composite financial cycle in standardised growth rates, where 0.5 denotes the historical median after removing a nonlinear trend; 0 is the smallest and 1 the largest growth rate observed in a country’s history

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Financial cycles vs business cycles

• Longer (8-20y) vs. (2-8y) and higher amplitude

• More symmetric

• More heterogeneous across countries

• Predict banking crises better

Stylised financial cycle

The financial cycle

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Source: Segoviano (2006), “Consistent Information Multivariate Density Optimizing Methodology”, IMF Working Paper.

Joint distress across financial institutions

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Source: Segoviano and Espinoza (2017), “Consistent Measures of Systemic Risk”, IMF Working Paper.

Joint distress across financial institutions

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Rubric Endogeneity of systemic risk

Source: Segoviano, Bochmann, Hiebert and Schüler (2018), “Latent fragility: Conditioning systemic bank distress on the financial cycle”, IMF (Mimeo).

Trend

Time (quarters)

Peak

Trough

High buildup of financial system vulnerability

Low buildup of financial system vulnerability

Low market-implied probability of bank distress

High market-implied probability of bank distress

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Endogeneity of systemic risk


Adverse financial conditions

Benign financial conditions

• As financial conditions worsen the set of events where A, B and C are in default expand…

• … so does the amplification

magnitude in case of further deterioration of financial conditions

• … and banks deleveraging will further depress financial conditions


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Source: Segoviano, Bochmann, Hiebert and Schüler (2018), “Latent fragility: Conditioning systemic bank distress on the financial cycle”, IMF (Mimeo). Note: Euro area regional financial cycle, JPoD computed for seven large euro area banks with availability of Moody’s 1 year EDF using the CIMDO approach of Segoviano and Espinoza (2017).


Financial cycle and joint distress probability, euro area

1E-10

1E-09

1E-08

0.0000001

0.000001

0.00001

0.0001

0.001

0.01

0.1

1

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

Financial cycle (lhs)

JPoD (rhs; log %)


Financial cycle and conditional joint distress probabilities (log scale), euro area

Source: Segoviano, Bochmann, Hiebert and Schüler (2018), “Latent fragility: Conditioning systemic bank distress on the financial cycle”, IMF (Mimeo). Note: Source: Segoviano, Bochmann, Hiebert and Schüler (2018), “Latent fragility: Conditioning systemic bank distress on the financial cycle”, IMF (Mimeo). Note: Euro area regional financial cycle, JPoD computed for seven large euro area banks with availability of Moody’s 1 year EDF using CIMDO approach of Segoviano and Espinoza (2017).


Source: Segoviano, Bochmann, Hiebert and Schüler (2018), “Latent fragility: Conditioning systemic bank distress on the financial cycle”, IMF (Mimeo). Note: Source: Segoviano, Bochmann, Hiebert and Schüler (2018), “Latent fragility: Conditioning systemic bank distress on the financial cycle”, IMF (Mimeo). Note: Euro area regional financial cycle, JPoD computed for seven large euro area banks with availability of Moody’s 1 year EDF using CIMDO approach of Segoviano and Espinoza (2017).

Financial cycle and conditional joint distress probabilities (levels), euro area

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Rubric Policy considerations: Coherence and tradeoffs


National financial conditions

Economic growth at risk

Vulnerability of financial

institutions

Structural macro and micro prudential policies

Cyclical macroprudential policies

Macroeconomic policies

Coherence of capital requirements?

Policy tradeoffs, lean vs clean?

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Source: Hiebert, Jaccard and Schüler (2018), “Contrasting financial and business cycles: Stylized facts and candidate explanations” Journal of Financial Stability, 38 (72-80) Notes: Boxplots show distribution of duration (in years) of cycle phases across 13 EU countries, 1970Q1-2013Q4

Financial cycles historically more symmetric than business cycles

Policy considerations: Asymmetries

Documents

Paul Hiebert Marrying the cyclical and structural dimensions of ... · Pre-crisis toolkit lacked instruments to tackle the financial cycle • Buildup of country vulnerabilities •